The Discount Factor explained.

The Discount Factor is a metric that determines the present value of $1. It is used when conducting financial modelling such as the discounted cash flow model (DCF) or the net present value (NPV) model. The Discount Factor is used to estimate the present value (PV) of receiving $1 in the future based on the expected date of receiving it and discount rate estimation.

Given the time value of money, a dollar today has greater value than a dollar next year. If a country has a current inflation rate of 4.5% that means $1 next year will be worth $0.955 of a dollar today. Forecasts therefore need to be discounted back to determine the company’s present value.

The formula uses the Risk-Free rate of return which can change pending on the user’s preference. It can take the 5 or 10 Year Bond rate, the interest return from a savings account or the return over other investments. As a private investor the discount rate is an opportunity cost of capital to value a business.

The risk–free rate is the rate of return offered by an investment that carries low or zero risk. It depends on factors like what country you are in, inflation, GDP growth, foreign exchange rate, and economy. It can also be independent to the investor as they may have other opportunities in different asset classes to place their capital.

I don’t think you should make up the risk-free rate, you should set it with reference to your real cost of capital, borrowing rates and investing options.

The discount and inflation rates are unrelated, all though you can incorporate them together into one discount factor. The discount rate considers various risks beyond inflation, which might equal the cost of capital. There are other ways to measure the Inflation Adjusted Returns.

The Risk-Free rate is a benchmark to measure an investment with the promise of a high return. When using our discount rate we are using it to help us determine the fair value of a stock in today’s price.

What is the Discount Factor Formula?

• DF = 1 ÷ (1 + RFR) ^n
• RFR = Risk-Free rate of return.
• n = Period of Years.

Let’s work out an example on a Risk-Free rate of 4.85% for 1 Year (My current Term Deposit rate of return with a bank). The 4.85% would equate to a Discount Rate of 1÷(1 + 0.0485)^1 = 0.0953 so this number becomes our discount rate for year 1 based on our rate of return.

Below is a table of the Discount Factor showing a risk-free rate from 1-10% over a 5 year period. This can be extrapolated over what ever period of time you want to measure the return. I use a 10 Year Discount Factor with the DCF model as I typically invest for longer periods of time.

How to use it?

The discount factor is used when we are conducting financial modelling to work out the future cashflow or intrinsic value of a company. We would take our Projected Growth Rate of the investment extrapolate that out over the period of time and then for each year multiply this number by our Discount Factor to determine the Present Value or DV (Discounted Value).

Let us work out an example of Company A using the EPS (Earnings Per Share). This is a simple chart expressing the DF formula at work and not an in depth analysis (modelling can be a lot more complex than this). We will use a risk-free rate of 5%.

So we have a current EPS of US $0.087 for the current year, and a CAGR (Compounded Annual Growth Rate) of 9%. This CAGR would become our Projected Growth Rate to work out the EPS assumption over 5 years. This is presented in the below table using our 5% risk-free rate.

We then multiply the EPS x DF for each year to arrive at our Discounted Value (DV) or Present Value (PV).

	2024	2025	2026	2027	2028
EPS	0.095	0.103	0.112	0.122	0.133
DF	0.952	0.907	0.864	0.823	0.784
DV	0.090	0.093	0.105	0.100	0.104

From here we can tally up the DV line to come up with the sum of the values giving us an estimated Intrinsic Value. We can use this for a range of models that all give us an assumption of future value as a share price or market cap in today’s price. To calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value.

In Summary…

The Discount Factor is an important formula to know and use. At the end of the day, we want to try and achieve 2 factors. 1) Determine if an investment that has a higher level of risk does provide us with a greater rate of return over a lower risk-free option and 2) Determining the value of an investment and whether it is undervalued or overvalued to help us achieve point 1 when buying.

I like to use Discount Rates that align with my own opportunity cost as I can place my capital in various asset classes for different returns.